Assessing Your Needs
Cash Flow Issues
Using Financial Ratios
The Product Life Cycle
Preparing a Strategy
Assessing Your Options
Borrowing from Financial Institutions
Other Sources of Funding
Glossary of Terms
Useful Contacts
Comprehensive financial analysis of your business will enable you to determine what it needs for survival and growth - whether extra funds, new management strategies or both.
Undertaken on a regular basis, comprehensive financial analysis can help you optimise the overall development of your business. It enables you to recognise opportunities, head off problems and gain feedback about the effectiveness of your management decisions.
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A business can develop cash flow problems for various reasons, including:
It is important to identify the reason for your cash flow problem and seek an appropriate solution, rather than just putting more money into your business.
What is the break-even point of your business?
When the sales revenue of your business equals the value of its obligations (both fixed and variable) it is at break-even point. Below that point it is operating at a loss; above, it is making a profit.
Look at your break-even analysis to see if you are trading profitably. Even if your business is operating above break-even, it can experience cash flow problems if a time gap arises between its outgoings and its income. You may have to pay your creditors more quickly than you can collect sales; or money may be locked up in raw materials or unsold goods. As a result, you may need to supplement the working capital of your business.
You can take preventative action to avoid cash flow problems if you use basic financial ratios to monitor your business, understand its cost structure and create cash flow budgets/forecasts.
Temporary cash flow problems can be managed by arranging appropriate short-term finance, eg:
Working capital and the cash cycle
A business earns money from the products and services it sells. It then spends these earnings on acquiring the inputs to create further products and services. The flow of cash varies at different points in the cycle. First a business needs to invest cash to acquire inputs; then it needs to sell its products and services to realise enough cash to cover the investment and make a return to the owners of the business.
Financial ratios are valuable tools for understanding and monitoring the performance of your business. They can help you manage more effectively by encouraging you to focus on operational aspects that are impacting financial performance. Different financial ratios are used for different management purposes. Some of the most common are shown here.
Profit margin: a measure of the effectiveness of your marketing; the ability of your business to earn a profit on every sale.
Asset turnover: a measure of the operational effectiveness of your business; how well assets are deployed to achieve sales. Assets include plant, machinery, stock, raw materials and accounts receivable.
Financial leverage: a measure of how effectively your business uses debt to boost return on equity or net assets.
Always interpret financial ratios in context - eg by comparing with historical records, business goals and strategies, industry norms and economic conditions:
Regular analysis of financial ratios can reveal trends that indicate the need for management action:
Understanding the four stages of the product life cycle can help you interpret changes in the financial ratios of your business.
Your business is likely to have an evolving portfolio of products, each at a different stage of the cycle. Nonetheless this concept offers some useful guidance.
Stage
Typical effect on financial ratios
Start-up
Growth
Maturity
Decline
If after careful analysis you have decided to seek extra finance for your business, you need to:
Pro forma cash flow budget/forecast
To prove that your business represents a worthwhile investment, you will need to present your situation and strategic response as clearly and convincingly as possible.
Setting out the facts in this way will give you added confidence in your actions and decisions. It also prepares you to identify and successfully target a potential investor. Investors need to know how you will use the money that they are being asked to put into your business.
Typically, growth will require an increase in working capital and investment in fixed assets. Working capital needs are usually met by an increase in short-term debt (eg an overdraft), while needs for investment in fixed assets are met by long-term debt and/or equity.
Short-term trading difficulties arising from changed economic conditions or from losing ground to competitors should be met by an appropriate strategic response - for example, by cutting costs, developing products or undertaking business development activities. Funds can be sought specifically to carry out such strategic actions.
Financing Strategies
There are two basic types of finance: debt and equity. There are also a number of strategies to raise finance that go beyond these approaches, including:
Debt or Equity Funding?
Debt and equity funding are each appropriate to different business needs and have very different implications.
Debt funding
Debt financing is appropriate when funds are required to finance a specific asset and you are confident that the cash flow in the business will allow you to service the loan. Debt is useful to leverage returns from your business and helps multiply the return on your equity investment in the business. Generally, you should match the term of a debt to the expected life of the asset being financed. Working capital should be financed by overdrafts or other short-term debt, while the purchase of fixed assets should be financed by appropriate term loans.
Before agreeing to lend money to your business, an investor or institution needs to be convinced that the business will be able to make interest payments on time and repay the capital on maturity.
Debt agreements cover such issues as the interest rate; how interest is to be calculated; the frequency of repayments; and the term of the loan. Other conditions in a debt agreement may include limitations on dividend payout ratio and the maintenance of current and other financial ratios. If the agreement is breached the loan and interest may become payable in full immediately.
While debt can usually be negotiated quickly, its terms can be inflexible. However, the interest paid on a debt is a tax deductible expense.
Equity funding
Equity funding is an option that will inject funds into your business and can help introduce new management ideas. The owners of a company are its equity holders. Thus anyone investing in the company's equity is buying part ownership. While the original owners can end up with a smaller proportion, issuing equity can also significantly enhance their wealth.
Equity holders can only claim the residual earnings of a business (ie after all other claims have been met). These are paid out as dividends based on each owner's share of the company.
The case of Yahoo.com demonstrates how business owners can grow their wealth by selling down part of their equity interest as the business grows. David Filo and Jerry Yang started Yahoo.com as a web index in 1994. Later that same year they sold 25% of the company to Sequoia Capital for $US1 million - a transaction that valued their 75% ownership at $US3 million. After selling further shares of their equity to five venture capitalists and listing on the stock exchange, at one stage the value of the co-founders' remaining 31.5% shareholding reached a staggering $US6.65 billion.
The cost of equity capital, or the return that equity investors require on their investment in the firm, is high because investors regard equity investment as risky. They may seek a role in managing the company, or place conditions on its governance to manage their risk when investing in your business.
Organising equity funding by public listing or venture capital typically takes up to 12 months. Equity funding from family and friends can usually be arranged relatively quickly.
The major banks and other financial institutions offer a wide range of business financing products.
Check each bank's website for its terms and facilities, which change frequently. The interest rates for banking products are advertised in major newspapers on the first Monday of each month.
Overdrafts and lines of credit are useful for smoothing cash flow peaks and troughs. They are flexible, usually short-term, expensive to service and must be secured by property or a charge over the business and its assets. However, some banks provide established companies with smaller lines of credit (up to $50,000) without requiring specific security.
Bank bills are useful for funding inventory holdings and stock purchases. They provide a fixed advance (amounts over $100,000) that is repayable or rolled over relatively quickly (eg within 30/90/180 days). Although generally less expensive than overdrafts, they require similar security. Sometimes offered as managed/structured bill lines for up to five years, as alternatives to overdrafts.
Business or term loans are ideal for project or development finance. They provide up to $2 million fixed funding, repayable in equal instalments over the term of the loan (up to 25 years). Real estate security is frequently required, making these loans particularly affordable when home loan interest rates are low.
Leasing, hire purchase (HP) and other asset-based finance products are available from banks, their associated subsidiaries and industry-specialist lessors and are useful for funding the acquisition of company assets (eg motor vehicles, computer equipment, major production machinery). The standard of security and capital value tend to be lower than for mainstream bank products and the true interest rates higher.